Market Update

The S&P 500 rose 3.8% to finish the week at 4712.02. It is less than 1% away from the record high of 4743.83 set November 22nd. The Dow gained 4.0% and the Nasdaq rose 3.6%. It was a strong week for stocks. Bonds were weak. The iShares 20+ Year Treasury Bond ETF (TLT) fell 3.6% on the week. TLT is down 4.28% year-to-date. The Vanguard Short-term Treasury index ETF (VGSH) is down 0.6% year-to-date. Treasury bonds are considered safe investments. They are not safe now, given the likelihood of rising rates over the next 10 years. Real interest rates are negative, not a normal situation. Real interest is the interest you pay minus the inflation rate. Currently, the 10-year Treasury is yielding 1.48%. The Consumer Price Index (CPI) is up 6.8% year-over-year. The real 10-year Treasury yield is negative 5.32%. Borrowers are paid to borrow.

Credit hasn’t been this cheap since March of 1951. Real interest rates were negative during the second half of the 1940s and early 1950s. The U.S. allowed inflation to rise while suppressing interest rates. The financial repression of that time was in response to the high debt taken on during World War II. Inflation is high and rising now. The hope is that it is temporary. The reality is that much of it is not. The Federal Reserve will not be able to ignore continued high inflation numbers. In fact, the Fed is expected to announce a more rapid taper at its December 15th meeting. A growing number of market strategists are predicting the first hike in May. They see two more by year-end 2022.

Liquidity has driven much of the bull market that started in March 2009. The S&P 500 index has risen far faster than earnings. Shiller’s P/E bottomed at 14.12 in February 2009. It is at 38.08 as of December 2021. Shiller’s P/E uses the average inflation-adjusted earnings from the last 10-years. The ratio has only been higher in the late 1990s. It peaked at 44.19 in December 1999. The next decade saw negative returns for the S&P 500 index for only the second time ever. The first time was during the Great Depression. Monetary tightening makes it more likely that stocks will fall in 2022 and/or 2023. The high price-to-earnings multiple means low returns over the next decade. Investors can still earn a respectable return by owning good companies on sale. Owning the entire market holds less promise.

Economic Indicators

Unit labor costs rose 9.6% in Q3. Productivity decreased by 5.2% in Q3. There are 11.0 million job openings in the U.S. and the job quits rate is 4.2 million, which is high. Almost 39 million people have quit their jobs this year, including a record 4.4 million in September. Initial jobless claims fell to 184,000, another strong jobs number. The CPI rose 0.8% in November and 6.8% year-over-year. Five-year expected inflation is 3.0%.

Put it all together and you have a recipe for continued inflation. Unit labor costs are worrisome. People get use to cost of living raises and begin to expect and demand them before long. The high job openings number, high quits rate, and low jobless claims number all scream tight labor market. Inflation is not likely to fall much in the near term. It may take several years to bring it under control. The Federal Reserve needs to navigate the rate hike cycle without triggering a recession in the process. It is walking a tightrope. The next few years will be interesting to say the least.

Mental Accounting and Investing

I had a conversation last week with a new client about what type of portfolio we were going to build for him. He’d done an in-service distribution, rolling some of his 401(k) plan money into an IRA with us. He also wanted to get advice on how to allocate the remaining money in his 401(k). Edward Jones is managing a third bucket of money for him as well. In summary, he has three different buckets of money. We will manage one. Edward Jones will manage one. He will manage one, but with some guidance from us.

Professional money managers usually view a household's investment assets as a single portfolio. It doesn't matter how many investment accounts are part of that portfolio. A single portfolio with a single risk level is the goal. The single portfolio is managed to meet the household’s spending goals in retirement. Knowing the risk level of the household portfolio is important. Professional investment managers want to know the exact asset allocation. They want to know the portfolio’s exposure to the various factors that determine returns. It is important to take on only as much risk as clients are comfortable taking. It is also important to take on sufficient risk to achieve the household’s spending goals. After all, we save and take on investment risks to achieve our spending goals. We don't take risks for the sake of taking risks, or at least we shouldn’t.

Someone needs to monitor portfolio risk. Someone needs to ensure that the multiple investment managers aren’t combining to take excessive risk. Unfortunately, my new client’s total asset allocation is murky at best. The Edward Jones portfolio is the typical expensive stealth index portfolio. It has 39 different mutual funds and ETFs. There is tremendous overlap among holdings. Many stocks are held by ten or eleven different mutual funds in the portfolio. The 39 holdings are there for show, to make it look as if the advisor is actively managing the account. Many of the mutual funds are highly correlated and provide no additional diversification. They are essentially the same investment. There is no evidence of active management in the Edward Jones portfolio. Unfortunately, there is excessive exposure to several risk factors. The client is not receiving value for the 1% advisor fee.

Unfortunately, the someone monitoring portfolio (as opposed to account) risk is the client. It is clear from our conversation that he sees the remaining money in his 401(k) as his “safe” money. He has elected to put it into the Fidelity Freedom Income fund. The fund holds about 20% stock, 20% cash, and the rest in fixed income. He is also moving some money from the S&P 500 index to international and emerging market index funds at our suggestion. He sees the money he is putting with us as his “aggressive” money. He likes that we invest in individual stocks. He likes that we buy good companies on sale. Companies with strong balance sheets, stable businesses that are paying above-average dividends. His Edward Jones money is in a moderate portfolio. It is somewhere between his “safe” money and “aggressive” money.

Three different accounts with three different amounts of money and three different allocations. It is a classic case of mental accounting. Safe money, moderate risk money, and aggressive money are thought of as distinctly different buckets with distinctly different purposes. Mental accounting leads to poor decisions, including suboptimal allocations. After all, money is fungible. Money from any bucket can be used for any spending goal. As well, too much "safe" money can lead to a failure to meet your spending goals. Too much “aggressive” money can leave you with more risk than you need. Overall, it is much more difficult to judge the risk level of your household portfolio. It is also harder to forecast expected returns, which is critical to creating achievable spending goals.

Norwood Economics usually drives the bus. Our new client is at the steering wheel this time. We hope he monitors his three-portfolio approach, maintaining an appropriate overall allocation, risk level, and expected return. Otherwise, his spending goals in retirement are in jeopardy.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist